Soundness, Profitability, and Growth -- Texas Capital BancShares Inc Has It All

Over the next month, banks will be releasing results for the second quarter. In advance of these releases, let's take a moment to review the state of some of these banks as of the end of Q1.

In this post, we'll take a look at Texas Capital BancShares (NASDAQ: TCBI) , a $121.4 billion bank headquartered in Dallas, Texas. You can find information on other banks at my Motley Fool article feed, available here. All data in this analysis was sourced from the FDIC's Quarterly Banking Profile and S&P Capital IQ.

When I evaluate banks, I follow a model made famous by former Wachovia CEO John Medlin: Soundness, profitability, and growth. As investors, we then take a look at valuation and the potential for investment after gaining a better understanding for each bank.

SoundnessSoundness refers to the bank's asset quality. Generally speaking, this means loans. If a bank makes loans that are never repaid, that bank will fail and fail quickly. The best banks put risk management first, ensuring that shareholder capital is protected if a portfolio of loans turns sour.

To measure this, we'll take a look at both non-performing assets and Texas Capital BancShares's provision for loan and lease losses. A simplified definition of non-performing assets are loans or other assets that have fallen seriously delinquent or are in foreclosure.

The provision for loan and lease losses is a reserve of money that the bank pulls out of its income each quarter to guard against future losses in the loan portfolio. Banks are required by regulation to maintain certain levels of reserves, but within that, management has plenty of wiggle room to over- or under-reserve. Over-reserving increases protection but hurts net income; under-reserving increases risk but keeps net income high.

For the quarter ending on March 31, Texas Capital had 0.38% non-performing assets as a percentage of total assets. The FDIC reports that banks with total assets greater than $10 billion on average had 1.5% non-performing assets as a percentage of total assets.

Texas Capital BancShares reserved $5 million for the first quarter, which represented 4.2% of operating revenue. This compares with 5% for the $10 billion+ peer group, according to the FDIC.

In terms of soundness, the numbers indicate a strong credit culture at Texas Capital. Problem loans are well below its peers, and the bank is still reserving a healthy amount of capital for future hiccups.

ProfitabilityAfter establishing an understanding of a bank's risk culture and soundness, next we can focus on profitability. Any investment in a business is an investment in that company's future earnings, so profitability is a particularly important consideration for any bank investor.

The first question, perhaps most obviously, is if the bank actually generates a profit at all. According to data from the FDIC, 7.3% of U.S. banks failed to generate a profit at all in the first quarter. That's one in every 14 banks!

For Texas Capital, the first calendar quarter of 2014 fortunately wasn't that bad. The company generated total net revenues of $118.7 million for the quarter -- that is total interest income plus non-interest income minus interest expense.

Over the past 12 months, Texas Capital has generated $450.9 million in total net revenue; 91% of that revenue was attributable to net interest income, the difference between interest earned on loans and paid out to depositors. The remaining 8.7% was through fees, trading, or other non-interest revenue sources.

The bank was able to turn a profit margin of 26% on that revenue.

For the first quarter, the company reported return on equity of 9.7%. Of the banks covered in this series of articles, the average return on equity was 8.9%. The FDIC reports that the average ROE for U.S. banks with total assets greater than $10 billion was 9.1%.

The beauty of a bank with this ratio of revenue in lending is that the business model is easy to understand: Collect deposits, make loans, and pocket the spread. On the other hand, its unclear why the bank is unable to generate a higher level of fee income. The bank sells standard deposit and loan products, as well wealth management and trust services.

The company, even without significant fee income, still generates a healthy profit with above-peer ROE. I see the lack of fee income as an opportunity instead of a flaw. The path for increased profits is clear.

LeverageIt's at this point we should probably discuss leverage. Leverage is a double-edged sword for banks and could easily fit into either the soundness or profitability categories. We'll call it a subset of both and discuss it here.

Leverage is just part of the game with banks, so if you're a conservative investor who really focuses on conservative capital structures, the banking industry may not be the best place for your money. Adding leverage is an easy way to juice return on equity, which is generally a good thing. The bank increases assets and thus earnings, while maintaining a lower capital level.

The result is a higher numerator, a constant denominator, and a larger return on equity number. The math does the heavy lifting for you.

On the flip side, too much leverage can put the bank on thin ice if the loan portfolio takes a turn for the worse. A stronger equity base protects the bank from bankruptcy and bailouts, two outcomes that are both politically charged and downright terrible for shareholders.

Banks use all kinds of esoteric and overly complex accounting methods to determine leverage. We'll keep it simple here with an old fashioned assets to equity ratio. The lower the number, the less levered (and more conservative) the bank.

Texas Capital BancShares's assets to equity ratio comes in at 9.9 times. The average of the 62 banks analyzed in this series of articles was 9.1 times.

Growth and ValuationTexas Capital BancShares saw its revenues change by 7% over the past 12 months. That compares with the average of the 62 banks analyzed of 5.7%.

This change in revenue corresponded with a -8.3% in net income over the same period. The peer set averaged 14.1%.

54% of all U.S. banks saw year-over-year earnings growth in the first quarter.

Moving now to valuation, Texas Capital BancShares traded at a forward price to earnings ratio of 18.2 times according to data form S&P Capital IQ. This compares to the peer set average of 16.7 times.

Texas Capital BancShares's market cap is, at the time of this writing, 2.2 times its tangible book value. The peer set average was 1.9 times.

Many investors use a general rule of thumb of buying a bank stock when the price to tangible book value is less than 0.5 times, and selling when it rises above 2 times. For me, that method is way too oversimplified.

It sometimes makes sense to pay a premium for a bank stock that places a high value on credit culture and asset quality. These banks will survive and prosper, while others fall by the wayside. That security can be worth a premium. Likewise, a bank that relies heavily on leverage to achieve above average return on equity may not be worth the price, even if its price to tangible book value is low. That risk may not justify even a healthy discount in price.

Based on the factors we've discussed here -- soundness, profitability, and growth -- Texas Capital appears to be undervalued.

The company is built on a rock-solid foundation; its asset quality numbers speak for themselves. Its profits are strong, and there's a clear path for boosting profits without the need for new capital -- wealth management, trust services, and other fees require no additional financial investment and transfer nearly 1:1 to the bottom line. The company demonstrates strong growth as well, yet it still trades for only a marginal premium to its peers. I see the opportunity for long-term upside with Texas Capital Bancshares.

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